LESSON 4 – FINANCING DECISIONS
Financing decisions center on how a company pays for its capital projects. In a stable company,
the day-to-day operations of the business should pay for themselves: Revenue from sales should
be enough to pay for inventory, rent, utilities, workers' wages and so on. For big capital
investments, though, the company may need more cash than the business generates day to day.
The business can get that cash from two places: from owners or from lenders. When it uses
money belonging to the owners, it's called equity financing. When it uses borrowed money, it's
debt financing. The company can use either debt or equity or a combination of the two.
The primary goal of both investment and financing decisions is to maximize shareholder value.
Investment decisions revolve around how to best allocate capital to maximize their value.
Financing decisions revolve around how to pay for investments and expenses. Companies can
use existing capital, borrow, or sell equity.
Outright purchase is right for you?
When it comes to acquiring new assets for an organisation, one of the key questions that
many businesses face is: should we purchase the asset or lease it?
The answer to this question depends usually on your attitude to asset ownership, with many
companies preferring to lease their assets over time – where there is an even cash-flow over the
lease period – rather than owning them, which usually requires a significant cash outlay upfront.
When it comes to funding new assets, there are many facets to consider – in particular the cost of
the asset itself and whether budgets will allow for an outright purchase. It pays to lay out the
benefits of an outright purchase before committing to any agreement.
Should you buy business assets outright?
Some companies still prefer to purchase assets like plant and machinery, IT equipment and
vehicles, as there is a certain reassurance in owning assets outright. However, there are a number
of deciding factors to consider before taking the plunge and buying outright.
, Capital upfront and depreciating value
Purchasing assets outright typically requires a high outlay of capital initially, which may mean
tying up funds that could be better used elsewhere in your business, or by sourcing a bank or
other loan to cover the costs.
Remember, too, that most assets you own are depreciating assets and your business is therefore
exposed to any fluctuations in their residual value, which may be more severe than you would
like.
Bank loans and interest rates
Another issue you should consider if acquiring assets via a bank loan is that the bank will
typically insist on raising a charge over the other assets in your business as collateral or security
against the loan.
Some may feel that it is unnecessary or unwarranted to tie up other assets of the business in this
way just to secure an additional one.
Another factor to consider with a bank loan is that the rate of interest the bank will charge on the
loan will depend on your status with that bank – whether you are a new customer or a new
business start-up, and what credit rating you have with them.
This could determine whether the rate of interest you pay is relatively comfortable for your
business or downright draconian, and it should not be underestimated.
Interest rates in the High Street are currently historically low, although may not be as low as
some might think. And it’s also true to say that rates from second tier lenders are still relatively
high, and could be as much as 8-10% for SMEs and other small businesses, depending on
circumstances.
However, there are several disadvantages to buying equipment outright:
you have to pay the full cost of the asset up front which can affect your cash-flow
, you may need to use an overdraft or loan to fund the purchase – overdrafts can be
withdrawn at short notice and in some cases early repayment of loans can be demanded
small businesses might not get the same interest rate as bigger businesses.
you can’t easily spread the cost to coincide with money coming into the business
you are entirely responsible for the maintenance and repair of the asset, which can be a
risk if the equipment breaks down or needs replacing.
you won’t be able to take advantage of the tax benefits of deducting the cost of lease
rentals from your taxable income.
the value of the asset could depreciate over time and be worth less than you paid for it.
What are the benefits of buying outright?
One factor firmly in favour of owning rather than leasing assets is their tax treatment and the
capital allowances that can be claimed against them. If employing outright purchase, you are
treated as the owner for tax purposes and can claim capital allowances.
A case in point is the Annual Investment Allowance, which governs the amount of capital
investment companies can make in business assets, such as plant and machinery, but not
vehicles.
The threshold for the AIAs two years ago stood at just £25,000 per annum. Then, in 2013-14, the
Government took the decision to increase this limit to £250,000 and then doubled it again to
£500,000 for an extended temporary period until December 2015.
This means that, in the current tax year, any business that purchases its business assets can offset
the value of the assets up to a maximum of £500,000 directly against their taxable profits in that
year – a significant incentive for any small business.
Hire Purchase
A hire purchase (HP) also known as installment plan in the United States is an arrangement
whereby a customer agrees to a contract to acquire an asset by paying an initial installment (e.g.
Financing decisions center on how a company pays for its capital projects. In a stable company,
the day-to-day operations of the business should pay for themselves: Revenue from sales should
be enough to pay for inventory, rent, utilities, workers' wages and so on. For big capital
investments, though, the company may need more cash than the business generates day to day.
The business can get that cash from two places: from owners or from lenders. When it uses
money belonging to the owners, it's called equity financing. When it uses borrowed money, it's
debt financing. The company can use either debt or equity or a combination of the two.
The primary goal of both investment and financing decisions is to maximize shareholder value.
Investment decisions revolve around how to best allocate capital to maximize their value.
Financing decisions revolve around how to pay for investments and expenses. Companies can
use existing capital, borrow, or sell equity.
Outright purchase is right for you?
When it comes to acquiring new assets for an organisation, one of the key questions that
many businesses face is: should we purchase the asset or lease it?
The answer to this question depends usually on your attitude to asset ownership, with many
companies preferring to lease their assets over time – where there is an even cash-flow over the
lease period – rather than owning them, which usually requires a significant cash outlay upfront.
When it comes to funding new assets, there are many facets to consider – in particular the cost of
the asset itself and whether budgets will allow for an outright purchase. It pays to lay out the
benefits of an outright purchase before committing to any agreement.
Should you buy business assets outright?
Some companies still prefer to purchase assets like plant and machinery, IT equipment and
vehicles, as there is a certain reassurance in owning assets outright. However, there are a number
of deciding factors to consider before taking the plunge and buying outright.
, Capital upfront and depreciating value
Purchasing assets outright typically requires a high outlay of capital initially, which may mean
tying up funds that could be better used elsewhere in your business, or by sourcing a bank or
other loan to cover the costs.
Remember, too, that most assets you own are depreciating assets and your business is therefore
exposed to any fluctuations in their residual value, which may be more severe than you would
like.
Bank loans and interest rates
Another issue you should consider if acquiring assets via a bank loan is that the bank will
typically insist on raising a charge over the other assets in your business as collateral or security
against the loan.
Some may feel that it is unnecessary or unwarranted to tie up other assets of the business in this
way just to secure an additional one.
Another factor to consider with a bank loan is that the rate of interest the bank will charge on the
loan will depend on your status with that bank – whether you are a new customer or a new
business start-up, and what credit rating you have with them.
This could determine whether the rate of interest you pay is relatively comfortable for your
business or downright draconian, and it should not be underestimated.
Interest rates in the High Street are currently historically low, although may not be as low as
some might think. And it’s also true to say that rates from second tier lenders are still relatively
high, and could be as much as 8-10% for SMEs and other small businesses, depending on
circumstances.
However, there are several disadvantages to buying equipment outright:
you have to pay the full cost of the asset up front which can affect your cash-flow
, you may need to use an overdraft or loan to fund the purchase – overdrafts can be
withdrawn at short notice and in some cases early repayment of loans can be demanded
small businesses might not get the same interest rate as bigger businesses.
you can’t easily spread the cost to coincide with money coming into the business
you are entirely responsible for the maintenance and repair of the asset, which can be a
risk if the equipment breaks down or needs replacing.
you won’t be able to take advantage of the tax benefits of deducting the cost of lease
rentals from your taxable income.
the value of the asset could depreciate over time and be worth less than you paid for it.
What are the benefits of buying outright?
One factor firmly in favour of owning rather than leasing assets is their tax treatment and the
capital allowances that can be claimed against them. If employing outright purchase, you are
treated as the owner for tax purposes and can claim capital allowances.
A case in point is the Annual Investment Allowance, which governs the amount of capital
investment companies can make in business assets, such as plant and machinery, but not
vehicles.
The threshold for the AIAs two years ago stood at just £25,000 per annum. Then, in 2013-14, the
Government took the decision to increase this limit to £250,000 and then doubled it again to
£500,000 for an extended temporary period until December 2015.
This means that, in the current tax year, any business that purchases its business assets can offset
the value of the assets up to a maximum of £500,000 directly against their taxable profits in that
year – a significant incentive for any small business.
Hire Purchase
A hire purchase (HP) also known as installment plan in the United States is an arrangement
whereby a customer agrees to a contract to acquire an asset by paying an initial installment (e.g.
